Typically, the US energy sector trades in tandem with oil prices. The sector is largely made up of household names like Exxon and Chevron, involved in exploration and production. They are known as "upstream" producers. These companies’ profit margins are closely tied to the price of oil, so we expect the markets to speak to each other.

However, over the last three years we have witnessed a breakdown in this relationship. In the time since it bottomed in the first quarter of 2016, oil has gained $21/barrel, but energy stocks have underperformed the main US stock market index, the S&P 500, by 12% per annum.

There is a clear disconnect, and this widening gap shown in the chart below has caught the eye of the multi-asset investment team this month.

Multi-asset chart of the month

Past performance is not a guide to future performance and may not be repeated.

The energy sector’s underperformance versus oil suggests there could be the potential for it to ‘catch-up’ in the future, although this is by no means guaranteed. Could such a trade be too good to be true?

What is happening?

As a commodity, the price of oil is primarily driven by supply and demand. Concerns about sluggish global growth and oversupply have been met with worrying headlines, particularly regarding Iran sanctions and Middle East tensions. Together they’ve swung oil prices — most recently into positive territory. Yet shares in the energy sector continue to underperform.

Unlike in the past, energy stocks are gaining less when oil goes up than they are falling when the oil price goes down. Simply put, the stock market does not appear to believe in the sustainability of oil prices.

This anomaly has notably played out over the past several months. In May and June this year, five oil tankers were attacked in the Gulf of Oman. As a sudden negative shock to oil supply, this should have been a boost to the price of oil and energy stocks, but the latter underperformed the US market by 3%.

Then again in September we saw tensions flare up further with a surprise drone attack on Saudi Arabia’s main oil processing plant.

Energy stocks reacted strongly, but there was no sustained rally; within weeks the sector retreated below pre-attack levels.

What are the repercussions?

The energy sector is now trading at a record cheap valuation. One measure of valuation is the price- to-book ratio. This is calculated by dividing a company's stock price by its book value per share, which is defined as its total assets minus any liabilities.

Currently the price to book ratio of the energy sector as a whole is in the bottom one percentile of its 30-year history.

However, companies’ earnings are weak and year-on-year growth is poor, which justify these almost rock-bottom valuations. The chances of an improvement to earnings don’t look promising, and investors want to pay for earnings that are predictably good.

This means that the market sentiment for energy stocks has turned decidedly negative with more money leaving the sector than being invested into it year-to-date. And though the energy sector was once 10% of the S&P 500 as recently as 2013, the sector now represents less than 5%. Energy is close to being forgotten, and even a turn in performance may not be enough to tempt investors back into this tiny corner of the market.

How do we interpret it?

Energy requires a strong upturn in the economic cycle to outperform. The ongoing trade war is having a meaningful impact on global demand while on the supply side, this year’s geopolitical risks have mostly been isolated to the Middle East. They are therefore unlikely to have a meaningful or lasting impact on global activity.

Ongoing US-China trade tensions further explain equity investors’ pessimistic outlook. Currently the market is weighing headwinds from trade tensions, recession signals from the US yield curve, and potential disruption in the euro area because of a disorderly Brexit. Altogether this acts as a drag on global growth, and therefore demand.

The sector faces serious headwinds from the transition towards next-generation energy solutions. The cost of renewable sources is expected to decline driven by economies of scale and improving technology, which will create competitive pressure.

How are we positioned?

The multi-asset team at Schroders is currently neutral on energy stocks. We acknowledge that valuations are compelling but believe the sector lacks the catalysts for a sustained upswing in performance. Energy cannot deliver that until we see a turn in the cyclical data.

At the moment we can afford to be patient, but energy could be a good opportunity when the data turns.

Please remember that the value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

This marketing material is for professional investors or advisers only. This site is not suitable for retail clients.

Issued by Schroder Investment Management Limited, 1 London Wall Place, London EC2Y 5AU.Registered No: 1893220 England. Authorised and regulated by the Financial Conduct Authority.For your security, communications may be recorded or monitored.

On 17 September 2018 our remaining dual priced funds converted to single pricing and a list of the funds affected can be found in our Changes to Funds. To view historic dual prices from the launch date to 14 September 2018 click on Historic prices.

Compliance statement

Please note this website is for professional investors and their advisers, trustees of pension schemes and consultants in the UK only and should not be read, used or relied upon by retail clients or members of the public. Retail clients should refer to the UK Investor Centre. Reliance should not be placed on the views and information on the site when taking investment and/or strategic decisions.

Nothing in this site should be construed as being personal financial advice. Should you have any queries about your application or the suitability of any of the investments included on this website for your personal circumstances, you should contact your Financial Adviser.

Please select the category that applies to you:

Local Authority Pension Schemes – Opted-up to professional client status by Schroders

UK DC Scheme Member

UK Consultant

UK Charity

UK Insurance Sector

Other (non-institutional investors)

Schroders uses cookies to personalise and improve your site experience. You can accept all cookies by selecting 'I agree' and continuing to browse the site or you can "Manage cookies" to apply only the categories of your choosing. Find out more details on how we use your information in our Cookie Policy.